The Surprising Dual Winners of the Energy Transition – OPEC and the New Technologies: Shale, Solar And Wind

There are a lot of new arrivals at the low-end of the energy cost-curve – but OPEC may yet adapt.

Summary

US shale and global solar / wind energy technologies are now competing strongly with the traditional oil and gas industry: these new technologies continue to grow in size and their costs are declining quickly due to scalability and learning effects.

The new players are also dispersed, decentralized and respond to market forces and pricing rather than any coordinated policies

This intense competition will force OPEC and other major national oil companies to rapidly change to compete on price rather than cost-plus market control.

A surprising outcome of this may be that OPEC along with the new energy technologies emerge as the dual winners of the energy transition.

Polar opposites in many respects, these two blocs have similarities in terms of self-organised decision-making, technological scalability and vast reservoirs of energy to rely on.

These are qualities that international energy companies, for all their financial and engineering heft, chronically lack – as likely losers, they will need to quickly develop exit and harvesting strategies.

Although unwelcome news inside the offices of many international oil firms, this is likely a good result for global energy consumers, and potentially a stable political outcome as both winners adjust to the new energy reality.

The Long Dominance of National Oil and Gas

For as long as oil and gas have dominated the global energy industry, large scale national producers have dominated oil and gas.

This is simply because massive oil and gas fields, especially conventional onshore ones centered in a single area, are very cheap to develop.

To be more precise, large national hydrocarbon reservoirs allow efficient scalable engineering to maximise production, and large national oil companies have clear lines of control to take decisions.

For these reasons the benefits of scalability and control often outweigh the drawbacks of state-owned enterprises, such as bureaucratic costs and limitations of in-house technology.

The impact of this is clear when comparing the reserves data (as a proxy for reservoir size) and unit costs of a large national producer such as Saudi Arabia, and that of a more costly, internationally-managed offshore producer, for example the UK – see below.

This is not a simple correlation, as some producers with large reserves – eg Venezuela and Canada – also have relatively high costs due to the heavy, viscous nature of their crude, requiring expensive processing investments.

But generally, large conventional reserves tend to dominate oil and gas supply for very fundamental reasons.

Big Scalable Energy Reserves are Resilient

When oil prices surged in the early 1970s, many international firms explored for large, scalable non-nationalised oil reservoirs.

The UK itself was able to exploit new, big fields such as Brent and Forties – both large enough to accept copy-cat production platforms, and provide reproducible cost reductions from the learning effects of standardized construction.

The last 20 years can therefore be seen as the epic challenge of international energy firms attempting to remain competitive with the enormous endowment benefits of giant reservoirs in the Middle East and other countries such as Russia.

Initially this was an equal fight due to the large size of discovered fields in, for example, the North Sea and North Slope of Alaska.

But each new reservoir involved a unique set of engineering characteristics, requiring long-cycles of design and construction of over a decade or more, placing heavy obstacles to managerial control and corporate learning.

In addition, access to large non-OPEC fields often came with complex commercial requirements.

For all their wealth, large international oil companies could not operate large fields alone, and so they set up multiple joint venture partnerships with national or international energy firms to finance the portfolio of investments.

An era of megaprojects had begun: but although large in size, these projects were not scalable, being technically, commercially and organisationally complex and inflexible.

Access to large oil fields required detailed relationships with state governments, local employment requirements, tax formulae and so on.

And the ability to increase or decrease production via investment decisions with many stakeholders was protracted.

Production was consequently delivered in rigid, long-cycle lumps.

As a result, total costs started to overcome any reservoir size benefits – the chart below shows, for example, how larger-sized LNG projects unit costs actually started to grow rapidly from around 2005 as the international megaproject era got underway.

Most of these megaprojects – estimates ranged from 60-90% – ran well over cost and schedule, causing Flyvbjerg et al to label it an Iron Law: “over time, over budget, over and over again.”

So as oil prices moved beyond $120/bbl after 2010, international oil company return on capital actually dropped, moving into lower single figures, even as their dividends and share buy-backs rose – attractive international megaprojects at $120/bbl were, it seems, typically hard to find.

Meanwhile, OPEC reservoirs remained vast, exploitable by decades-old scalable technologies, and developed by in-country national oil firms, with international technical support if required: add a processing unit here, a separator there and another 5% production could be added (or put on hold) over the timescale of months, rather than years.

As a result, by 2015, Saudi Arabia’s oil reserves to production ratio remained at over 60 years; that of the UK, for example, had fallen to 8.

source: BP

There are many reasons for the volatile price of oil, but this unbalanced supply structure of simple scalable output overlaid by complex, inflexible production is a major contributor to price swings over the past two decades.

Production tended to move in stops and starts, with limited synchronization toward overall demand.

OPEC’s continued dominance of the global energy sector is due to this industry structure. It has only having ever faced significant competition from the exact same energy product, crude oil and gas, provided at higher cost, and less adaptably.

Whilst international firms continue to work hard managing their rising cost base, and can exploit some supply chain reductions, their break-even costs continue to rise over time.

Only an alternative, scalable energy technology with very large energy reservoirs can really compete with OPEC’s dominance.

And as it happens, the last period of high prices allowed two to turn up at the same time – which changes everything.

The Manufacturing of Energy

Since 2010, when oil prices were on a seeming plateau of $100/bbl, two new forms of scalable energy technology with access to vast energy resources emerged: utility scale PV solar and turbine wind power, and US shale oil and gas.

The two technologies are often contrasted as they sit across an ideological divide between renewables and fossil fuels: but they share the fundamental properties of immense energy access and scalable engineering.

Solar and wind technologies use the infinite energy resource of the sun, plus globally manufactured equipment to capture and convert it into useable applications, typically electric power.

They therefore benefit from the widespread experience curve benefits of any mass-produced technology such as IT equipment, electronic goods or automobiles, coupled with the benefit of simple transfer of design and production facilitated by the internet.

And unlike major international oil and gas projects, wind and solar projects can be developed at various scales, from a few MW costing a few million dollars to a GWs costing hundreds of million, straddling three orders of energy magnitude.

Timescales to provide wind and solar energy are also relatively fast: they mostly range from several months to a couple of years, and they can be delivered in multiple phases, so energy is produced early and then supplemented – large international oil and gas projects normally offer nothing in terms of energy or financial payback until they are fully complete.

Like wind and solar, US shale oil and gas combine vast energy resources with scalable engineering. The technology is based on the repetitive construction of thousands of similar production wells using mature fracking techniques across a series of huge basins.

By some measures, US hydrocarbon reserves now rival those of Saudi Arabia and Russia at over 250 billion barrels. This unites the benefits of giant reservoirs, efficient engineering and a well-established commercial framework to work within.

As shale, wind and solar technologies developed across the high oil price era of the past decade, unit manufacturing costs dropped rapidly. The chart below indicates how the cost curves continue to reduce rapidly even as the technologies enter a larger, mature industrial scale from 2013 onwards.

For wind and solar, as the Lazard report from 2016 notes, they are now competitive with oil, coal, oil and gas-fired power plants for electricity on a levelised cost basis, increasingly without subsidy.

Costs are now below $50/MWh, and continue to fall via commercial innovations such as auctions.

These charts from the US Department of Energy (EIA) show historic growth from 2010 and central projections out to 2040.

source: EIA Annual Energy Outlooks
From a combined total of about 4 million barrels per day of oil equivalent in 2010, shale oil and gas will potentially produce 12 million b/d in 2020 on current projections.

Taken together, wind, solar and shale oil and gas could contribute about 17 million b/d of oil and gas equivalent energy by 2020, a four-fold increase on 2010.

The Clash, and Perhaps Co-existence, of OPEC and New Energy Technologies

It is perhaps worth summarizing the key elements of scalability – both technical and commercial plus organizational – that we have discussed.

This is captured in the table below looking at the state of play now amongst key players: the National Oil Companies (NOCs), lead by OPEC and Russia, the International Oil Companies, Exxon, Shell, BP and so on (IOCs) and the new technologies, shale, wind and solar.

Table 1 – Comparison of Key Energy Industry Players, 2017

source: BP, EIA, dollarsperbbl

OPEC and the IOCs still dominate current supply volumes, providing over 90% of the total. But both show low or negative growth, whilst the new technologies are developing and growing rapidly. This will force one or both these incumbents energy groups into decline.

The perhaps surprising fact is that both the traditional NOCs in OPEC and the new technologies may have the more efficient energy business models: scalable technologies, large energy resources and clear decision-making processes, whether hierarchical or market-based.

The most vulnerable energy suppliers are now are the IOCs: they have low-scalability technology and complex reservoirs which push up unit costs, and complex stakeholder and JV organizational structures that blunt decision-making capability.

A recent chart from Goldman Sachs highlights this entry of several new players at the low-cost and high-speed end of the energy supply curve. It is reproduced here with the addition of solar and wind, emphasising the growing shift away from the international mega-scale model.

These trends are further highlighted below using actual production of oil and gas for the main groups: OPEC, Russia, US non-shale and shale, wind and solar, and all other conventional suppliers.

In addition, the production is extended to 2020 using the main assumptions shown: specifically OPEC growing at 2% pa as in 2010-15, Russia and US non-shale essentially flat, US shale as per US energy department (EIA) central projections, and wind / solar growth at 15%pa as per IRENA and other analysts. Overall demand is projected to grow at 1%pa in this analysis, in line with various projections.

Based on the assumptions in this scenario, it’s clear that wind, solar, shale and OPEC production grow at the expense of international oil and gas – which as a group potentially lose over 100 million toe pa in supply by 2020, or nearly 2 million b/d.

This scenario of course places international oil and gas supply as the net residual between overall growth, and the growth of all the other main players.

Reality, of course, will play out differently as various players react to changing circumstances: international energy producers may access adjacent markets such as coal and nuclear. OPEC may decide to continue to restrain production, policies slowing solar and wind may emerge, and so on.

But whether or not the exact numbers prevail, three new features of the energy industry in the next few years and beyond are clear:

• There are now large-scale shale and solar / wind energy technologies competing with the oil and gas industry which did not exist even in 2010 – these technologies continue to grow in size and their costs are declining quickly due to scalability effects
• These new players are dispersed, decentralized and respond to market forces and pricing rather than any coordinated policies
• This new competition will likely force OPEC and other major national hydrocarbon producers to rapidly change to competing on price rather than market control

These trends lead to the perhaps surprising outcome of winners at both ends of the energy spectrum: the established NOCs of OPEC and Russia, and the new manufactured energy technologies of US shale, and global wind and solar power.

Polar opposites in many respects, these two blocs share deep similarities in terms of self-organised decision-making, technological scalability technological scalability and vast reservoirs of energy to rely on: qualities that the international oil majors, for all their financial and engineering heft, chronically lack.

The Quickly Changing Face of 21st Century Energy

The face of energy in the 21st century is transforming from a vast monolithic thermal fuel infrastructure into a more diverse array of scalable energy technologies.

The energy industry is therefore headed to a market-based, price-driven structure rather than producer-based, cost-driven one, where scalability and rapid adaptation will be key.

It is a clash, and perhaps accommodation, of two very distinct forms of energy supplier: large, low-cost resilient national hydrocarbon producers, and highly scalable dispersed energy conversion technologists.

As the energy barrel becomes increasingly dominated by low-cost hydrocarbons and low-cost scalable energy technologies, a new era of more autonomous and cheaper energy will start to emerge: more dispersed, more diverse, more innovative, less polluting and at lower prices.

Each major player will have to adjust to the new conditions – and soon.

Let OPEC be OPEC

For OPEC, Russia and other major NOCs cutbacks in production will need to end as they are unlikely to influence price: there is now too much energy competition, and too little growth to be manipulated by cartel controls. That era is over.

Their clearest strategy – and one which comes far more naturally to OPEC members than coordinated discipline – will be to maximize national production, and adapt business strategy and budgeting to long-term lower prices and increased volumes. OPEC states and Russia have the capacity to do this efficiently, and with economies of scale could largely offset top-line revenue loss.

Shale, wind and solar will continue to develop with a sharp growth trajectory. Shale’s lower cost curve and wind and solar’s global technology reach will allow them to emerge as energy industry cost leaders.

Their decentralized, market nature will also foster innovation and adaption as the market moves to a price-driven structure.

Both the large NOCs and new technologies will therefore find substantive areas of the energy market where they can offer differentiation: low cost thermal fuel applications or global, low-cost, clean, locally-manufactured power.

The outlook for the high cost international fuel providers is more negative: squeezed between scalable technologies, and with a rigid business model, their adjustment will be sharp and uneven.

However, most international oil and gas companies will not pursue this tactic.

They will remain married to long-term production increase strategies, assuming a cost-plus era overseen by OPEC will return.

This is a strategic dead-end.

These companies need instead to – quickly – turn to exit strategies: close-down exploration programs, retreat from long-cycle projects and concentrate on leveraging lower-cost production assets. In short, smart harvesting of resources to avoid sharp losses and emergency business restructuring.

The future, happening now, will instead belong to highly-scalable thermal and conversion energy players who have vast local or universal reservoirs of energy to rely on.

Although unwelcome news inside the offices of many international oil firms, this is likely a good result for global energy consumers, and potentially a relatively stable political outcome as both winners adjust to the new energy reality.